Winners and Losers When Oil is $50 a Barrel

Major technological advances in horizontal drilling and hydraulic fracturing (fracking) have dramatically expanded U.S. oil and gas production. By year-end 2014, U.S. daily crude oil production from shale layers had increased 230 percent over 2010 levels, and total U.S. crude oil production had risen 67 percent.

Despite that dramatic, unprecedented growth, the price of West Texas Intermediate ("WTI"), used as a global benchmark for oil pricing, remained between $80 a barrel (bbl) and $110/bbl from October 2010 until late November 2014. The unrelenting and massive increase in U.S. oil supply should have driven down the global price of oil. It didn’t because as these new U.S. supplies were coming online, geopolitical conflicts were flaring up in key oil-producing regions around the world.

For example, there was a civil war in Libya. Iraq faced threats from ISIS. Both the United States and Europe imposed new sanctions on Iran, significantly curtailing its oil exports. All this had the effect of removing more than 3 million barrels per day from the global market, or roughly the same amount that was being added by the United States.

Other factors during this period that kept the price of oil steady include:

Major supply disruptions in Africa and the Middle East that significantly reduced their contributions to global supply.

The expectation that OPEC would function as it had in the past, as a cartel, cutting oil production and, thereby, stabilizing global crude oil prices.

However, in the last quarter of 2014, Saudi Arabia announced that it would not cut production and that it would not revisit the issue for six months. This was the inflection point, and the market finally began to respond to the increase in supply. A crude oil sell-off began in earnest, and prices began a downward spiral.

In June 2014, WTI peaked at $115/bbl.

By January 2015, it had dropped below $46/bbl (see Figure 1).

Why This Downturn Is Different from Others

Experts disagree about what the future will bring for oil prices and the oil and gas ("O&G") industry. Some believe that the NYMEX prices will recover this year. In late January, prices rebounded on what Reuters reported to be traders’ hopes that energy companies — including U.S. shale producers — would cut production to stabilize prices. Investor’s Business Daily reported that new permits for oil wells in the United States declined nearly 40 percent from October 2014 to November 2014, signaling a possible pause in shale oil production. Other signals of a potential rise in prices include the worsening political situation in Libya and the possibility that exploration and production ("E&P") and O&G services companies will cut capital expenditures and reduce the size of their labor force in response to the decline in price and drop in demand.

On the other hand, some experts see the change in the O&G environment as potentially more secular than cyclical, pointing to changing and possibly enduring supply and demand conditions. As production has increased, so has the amount of proved reserves in the United States — by more than 50 percent in the last half decade. And demand for crude oil continues to slide in key markets, decreasing by nearly 300,000/bbl per day in the Organization for Economic Co- operation and Development countries between 2013 and 2014, with those numbers expected to remain essentially flat for 2015 and 2016.

In addition, experts note that a significant share of production comes from low- cost, horizontal wells (see Figure 2) and that their breakeven costs likely will decline over time due to technology improvements, the sunk nature of many costs (including commitments for rail and pipeline transportation), and price reductions for land rigs, pressure pumping and so on. Lower breakeven costs could have the effect of keeping North American oil production steady, prolonging the current low-price environment indefinitely.

The Fallout from $50/bbl

E&P firms will face strong headwinds in 2015, but the dispatchability of shale oil operations — the ability of producers to ramp production up or down quickly in response to market conditions — could lessen the impact of lower prices on nimble operators.

As reported by the Financial Times, Bernstein Research found that from 2000 until very recently, oil companies consistently experienced increases in oil prices following final investment decisions; that is, projects approved between 2004 and 2011 saw an average rise of $18/bbl in the price of crude by the time those investments began producing. Simultaneously, much of this time period coincided with a stretch of very low borrowing costs.

This combination of reliably rising prices and affordable capital created a sustained surge in oil and gas investment, much of which was funded with debt rather than equity. TheFinancial Times found that oil and gas producers and refiners with debt both at the end of the 2008 crash and at the end of 2014 had, in aggregate, twice the amount of net debt at the end of 2014 and net debt-to- EBITDA ratios that had increased from 0.7 to 1.8.

As reported in mid-December 2014, Goldman Sachs reviewed the Top 400 global oil and gas projects, ranked by size, and concluded that no more than a third would break even at $70/bbl. At the same time, however, many of the highest-cost projects (for example, Kazakhstan’s Kashagan field) exhibit complex ownership structures and government involvement that make stopping them extremely difficult, if not impossible, particularly if the producing country is in need of revenues.

Conversely, shale oil production — the major factor driving the downturn in oil prices — is very easy to dial up or down. Spudding a shale well (commencing drilling) can take just a few weeks; ramping down an operation can be done in a matter of days. And many companies have announced plans in 2015 to continue drilling these wells without actually completing them (that is, beginning fracturing) — thereby conserving funds in the short term while positioning themselves to jump back into the market quickly should prices improve.

Winners and Losers

So who will gain and who will struggle if oil prices remain in the $45/bbl to $65/ bbl range for a sustained period of time?

Simply put, consumers will gain. Consumers include petrochemical producers, energy-intensive manufacturers (especially those that use petroleum or products whose prices correlate with petroleum), other industrial manufacturing operations, transportation, agriculture and the general consumer.

For example, petrochemical companies that use oil and natural gas as raw material will gain. With one of their largest operating costs significantly reduced, these companies will be more profitable and competitive on a global scale. Likewise, the U.S. Energy Information Administration projects that U.S. drivers each will spend about $550 less on gasoline in 2015 than they did last year, assuming prices stay low.

Conversely, most O&G producers and services companies will continue to struggle. This group includes highly leveraged E&P companies that are receiving far less income for every unit produced. E&P companies face difficult options: restructuring or streamlining operations, selling off assets, renegotiating with lenders and leaseholders or going into bankruptcy.

Companies active in the North Sea, for instance, substantially increased capital spending over the past five years. Because of ever-worsening production decline curves, they may flounder, as may regional and municipal governments dependent on oil revenues such as Aberdeen, Scotland, center of the North Sea oil services industry.

Given these financial pressures, there will be rapid consolidation in the U.S. E&P industry and also the O&G services industries. Alternative and emerging fuels — such as biofuels — may become less competitive as traditional fuels remain relatively inexpensive. To the extent there is carryover to natural gas prices, wind and solar companies will see erosion in their market as well. Coal companies and related businesses also may suffer, especially if natural gas prices remain low.

While the E&P sector as a whole will continue to struggle with diminishing returns and capital expenditure reductions, companies with the greatest efficiencies and strongest balance sheet will be better fitted for survival. For example, integrated oil companies engaging in exploration, production, refinement and distribution began cutting operating costs and capital expenditures in advance of the drop in crude oil prices. As a result, their balance sheets are strong and strengthening, with refining becoming more attractive than production.